February 16, 2009

A Team Production Approach to Corporate Law and Board Composition

In today’s world of
corporate governance, the board of directors of a publicly held firm[1]
(public company) will almost certainly be made up of a majority of independent
directors.[2]For example, both the New York Stock Exchange
and the NASDAQ require that a public company’s board have a majority of
independent directors and that the major corporate board committees—audit,
compensation, and nominating—be composed entirely of independent members.[3]Moreover, both stock exchanges require that directors meet certain
subjective and objective criteria before they can be considered independent.[4]In addition, proxy advisory companies, those
companies that help shareholders decide how to vote on company matters, have
their own enhanced independence guidelines.[5]This movement toward increased board independence
began during the 1990s but was given a big boost by the Enron scandal.[6]It is also a reflection of society’s evolving understanding of how a
public company is to be governed.As so
well expressed by Professors Margaret Blair and Lynn Stout, “[t]he notion that
responsibility for governing a publicly held corporation ultimately rests in
the hands of its directors is a defining feature of American corporate law;
indeed, in a sense, an independent board is what makes a public corporation a
public corporation.”[7]As discussed below, it allows the board of a public company to act as a “mediating
hierarchy;” that is, as an arbiter of disputes between the various stakeholders
that constitutes a public company.[8]Moreover, many believe that independent
boards can better monitor managerial opportunism and enhance firm performance
relative to management dominated boards.[9]

If independence is
critical, then one option to ensure board independence is to require that a
board be composed solely of independent directors.However, this is problematic because an all
independent board would lack the insights, knowledge, and understanding of
those who know the company best.This
would cause more harm than good in board decision-making.Therefore, a corporate board composed of a
majority but not entirely of independent directors appears preferable.

But having a majority
of independent directors means nothing unless these independent directors also
exercise “independence of mind.”[10]They must be able to make independent
judgments without being overly influenced by inside directors and executive
management.This, of course, is easier
said than done.Moreover, “independence
does not consider how the directors will contribute to the board’s
understanding of the firm’s core capabilities” and thereby help optimize firm
performance.[11]Thus, independence in itself provides little
in the way of guidance on how independent board members are to be selected.

The most important
criterion for selecting independent board members is to choose members who
enhance the efficiency of board decision-making.For that to occur, we must have an understanding
of how the corporate board of a public corporation operates in an efficient
manner.Professors Blair and Lynn
propose that in order for the corporate board of a public corporation to
operate efficiently, it must operate as a mediating hierarchy, consistent with
their team production approach to corporate law.[12]Given this understanding, this Essay proposes
that a team production approach should also be used in board composition so
that the board of a public company can have the best chance of effectively
carrying out its role as a mediating hierarchy.

For guidance on how we
should select board members using a team production approach, we rely on a
model outlined by Professors Allan Kaufman and Ernie Englander.[13]One of their major recommendations is that
the former and current Chief Executive Officers of other companies (outside
CEOs) should be forbidden from participating in key board committees—the audit,
nominating, and compensation committees, for example—in order to significantly
reduce their influence.[14]Even though we cannot yet recommend that
outside CEOs be totally eliminated from participation in these key board
committees, this recommendation does find support in our prior work on board
composition.[15]

In that work, we
posited that having a board dominated or heavily influenced by outside CEOs may
lead to what we referred to as “dysfunctional deference,” a regard for the
recommendations of board insiders and executive management so pronounced that
it stifles deliberation of a corporate board’s most important decisions.[16]Therefore, it is our position that corporate
boards of public corporations—as well as their audit, compensation, and
nominating committees—would be better off and less prone to error if they were
composed of no more than a minority of current or retired outside CEOs.

Part I of this paper
discusses Blair and Stout’s team production model of corporate law and how it
leads to understanding the board as a mediating hierarchy.Part II discusses Kaufman and Englander’s
team production model of corporate governance and its implication for board
member selection.Part III focuses on
how a team production approach, reinforced by our understanding of small group
decision-making, leads to the recommendation that the influence of outside CEOs
should be significantly reduced.We
conclude with a summary of how a team production approach should be applied to
board composition.

I. Team Production and the Board’s Role as a
Mediating Hierarchy

According to Professors Hansmann and Kraakman,
“[t]here is no longer any serious competitor to the view that corporate law
should principally strive to increase long-term shareholder value.”[17]In this worldview of corporate law,
shareholders indirectly sit on top of the corporate pyramid, as corporate
managers have an obligation to manage according to shareholder interests.[18]The
economic rationale for utilizing this “shareholder primacy norm” is that this
is the best way for our society to maximize “aggregate social welfare.”[19]

Yet,
logic, experience, and the law tell us something different.As discussed below, a review of statutory
corporate law shows us that corporate governance is clearly not structured to
achieve shareholder primacy.Moreover,
the courts very rarely look to such a norm when deciding corporate law cases.

A. Shareholders
and the Structure of Corporate Law

The biggest hurdle in understanding corporate
law is accepting the reality that the law does not provide ownership rights to
shareholders.Although shareholders do
own interests in the corporation by owning company stock, they do not have
ownership of the corporate entity.For example,
title to corporate assets is in the name of the corporation, not its
shareholders.[20]Perhaps most importantly, corporate assets are controlled by the
corporation’s board of directors, not its shareholders.[21]Without control, shareholders become merely the “recipient[s] of the
wages of capital.”[22]

Furthermore, while shareholders do have
potential claims to the residual profits of the corporation, it is the board of
directors that decides if a dividend will be paid, and how much the dividend
will be.Moreover, corporate law clearly
does not require the corporate board to follow the commands of its
shareholders.[23]Shareholders may ratify a board’s action, but the board must first
approve the action.[24]Even
if shareholders pass a unanimous resolution requesting the board to act in some
specific matter, the board has the legal right to ignore such a resolution.[25]

Finally, courts
adjudicating corporate law cases prefer to disregard shareholder primacy in
their decisions.Courts demonstrate this
preference by applying the business judgment rule; requiring shareholders to
make demands before filing a derivative suit or demonstrating demand futility;
making it clear that directors owe fiduciaries to the corporation, not just to
shareholders; limiting the requirement of shareholder wealth maximization to
unusual situations such as when Revlon duties are to be applied;[26]
and rarely finding directors financially liable for the decisions they make as
a board.[27]Therefore, it is clear that corporate boards, not shareholders, sit at
the top of a public company’s hierarchical pyramid.[28]

B. The
Board as a Mediating Hierarchy

Corporate law protects the value of
centralized authority as embodied in the board of directors.But why does corporate law have such high regard
for corporate board authority?Professors Blair and Stout’s team production theory of corporate law
provides a cogent explanation.

According to Professors Blair and Stout’s
innovative stakeholder approach,[29] it is more realistic to think of a public
corporation as a team of members who make firm-specific investments in the
corporation with the goal of producing goods and services as a team (team
production)[30] with the board of directors acting as a “mediating
hierarchy.”[31]These
board members serve the interests of the corporation.[32]Moreover, “the interests of the corporation, in turn, can be understood
as a joint welfare function of all the
individuals who make firm-specific investments and agree to participate in the
extracontractual, internal mediation process within the firm.”[33]Team
members are primarily made up of executives, rank-and-file employees, and
equity investors, but can also include researchers, creditors, the local community,
marketers, and vendors who provide specialized products and services to the
firm and shareholders, among others.[34]Any
person or entity that makes a firm-specific investment is a member of the
team.The result is “that no one team
member is a ‘principal’ who enjoys a right of control over the team.”[35]

In this innovative approach to understanding
the public company, the board of directors, composed primarily of outside
members who are also independent of the firm, provides a unique mediating
function.Not only does it have the
final authority on hiring and firing corporate officers, approving corporate
policy, recommending major transactions for shareholder approval, approving
executive compensation packages and the like, but it also acts“as an internal ‘court of appeals’ to resolve
disputes that may arise among the team members.”[36]In
this role, board members are “mediating hierarchs whose job is to balance team
members’ competing interests in a fashion that keeps everyone happy enough that
the productive coalition stays together.”[37]

As stated by Professors Blair and Stout, “[i]n
essence, the mediating hierarchy solution requires team members to give up
important rights (including property rights over the team’s joint output and
over team inputs such as financial capital and firm-specific human capital) to
a legal entity created by the act of incorporation.”[38]Consistent with this approach, corporate law requires boards to act
primarily as legal agents of their respective corporations, not the
shareholders.[39]This
does not mean that corporate boards will not act in the interests of
shareholders when they make decisions, but it does mean that they are not
required to give shareholder interests first priority.

C. The
Interests of Shareholders

The rationale for why
shareholders would accept such an arrangement is that team members, including
shareholders, “understand they would be far less likely to elicit the full
cooperation and firm-specific investment of other members [for fear of shirking
and rent-seeking] if they did not [all agree to] give up control rights” to a
mediating hierarchy (the board of directors), which has the responsibility of
allocating “duties and rewards.”[40]Moreover, the team production theory of
corporate law suggests that “a legal rule requiring corporate directors to
maximize shareholder wealth ex post might well have the perverse effect of
reducing shareholder wealth over time by discouraging non-shareholder groups
from making specific investments in corporations ex ante.”[41]

Furthermore,
shareholders can utilize the political clout they have with the corporate board
and the legal tools that they have at their disposal to advocate that the board give priority to their interests.[42]Direct engagement through communication with
the board, shareholder proposals, proxy contests, class actions under state
corporate or federal securities law, and derivative suits are all tools that
shareholders can use to encourage corporate boards to address shareholder
interests.

Thus, even though
corporate law gives shareholders certain unique rights and remedies, it is
clear that corporate law is structured not to support shareholder primacy but
to support the corporate board as a mediating hierarchy.[43]By protecting the ability of the corporate board
to act as a mediating hierarchy, corporate law encourages the firm-specific
investment of team members, making incorporation a desirable means for establishing
the rights and remedies of a public company’s team members.

II. Team
Production and Board Composition: Maximizing the Ability of the Board to Act as
a Mediating Hierarchy

As we have just
discussed, corporate law is structured to promote the ability of the board to
function as a mediating hierarchy.With
this understanding, board composition can be utilized to promote this value of
centralized authority, making the board a more efficient decision-making
body.To do so requires a team
production approach to board member selection, not just stacking the board with
current or former CEOs of other companies.The key is making sure that the board is composed of members who can
best understand how the company functions from a team production perspective.

Professors Kaufman and
Englander provide a team production approach to board selection that is consistent
with our goal: “the team production model asks that the board replicate team
members, both within and connected to the firm, who add value, assume unique
risks, and possess strategic information in the corporation.”[44]Those characteristics may manifest in a variety
of potential board members:

1. Value Contribution—Those employees who add
critical value to team production often include engineers or scientists and outside
suppliers of research and development such as universities.

2. Unique Risk—Stakeholders assuming unique risks may
include vendors who have customized their production of goods and services to
meet the particular demands of the company, employees and executives of the
company who have invested in the learning of non-transferrable skills, those
that provide unique sources of funding, and the communities where company
employment is concentrated and have made infrastructure investments to support
this employment.

3. Strategic Information—Employees able to provide
strategic information that adds significantly to board deliberations often
include executive management or employees with special skills—such as those
with expertise in accounting, finance, and marketing.[45]

Board members could
come from inside or outside the company, as long as they are representative of
the team.[46]For example, the engineers or scientists
representative of the critical technologies that are part of the company’s
production function can be from either inside or outside the corporation.[47]Given the ability to substitute outside
expertise for inside expertise, members of the board that come from outside the
firm essentially serve as proxies for the various components of the firm’s team
production, thereby allowing the board to meet its independence requirements.

Implementing a team
production approach to board composition would not require any change in the
way board members are selected, as selection would still occur primarily
through the board nominating committee process.The key would be making sure the board nominating committee buys into
this approach.Of course, if a public
company also has a mechanism for shareholder nominated directors, that process
should also consider how these nominees would blend with in the other board
members based on a team production approach.

III. Board Composition and Outside CEOs

For a public company’s
board to operate effectively as a mediating hierarchy, it must be composed of
members who can best implement that function of the board.As discussed below, both Kaufman and
Englander’s team production approach to board composition and our understanding
of small group decisionmaking lead us to conclude that a board will be better
off executing its role as a mediating hierarchy by constraining the number and
influence of current or former CEOs in their positions as outside directors.

A. Team
Production and Outside CEOs

The composition of
corporate boards of public companies with a majority of independent directors
have traditionally been composed of a large number of current or former CEOs as
outside directors.[48]In 2007, 47% of all newly hired independent
directors at S&P 500 companies were either active (33%) or retired (14%)
CEOs, even though that is down from 52% in 2002 (41% active, 11% retired).[49]However, a team production approach to board
composition supports a limitation on the seating of outside CEOs as board members.By having a significant number of current or
former CEOs as outside directors you potentially overweigh the board with
proxies for the current CEO who is already on the board.Of course, each outside CEO on the board will
bring to the table different attributes and strategic information than the
company’s current CEO, but still the risk is that by having too many outside
CEOs on the board, the board will not be representative of the company from a
team production perspective.Thus, a
board composed of too many current or former CEOs may not be able to act
effectively as a mediating hierarchy.

B. Group
Polarization and Outside CEOs

Our understanding of
small group decisionmaking also supports a limitation on the number of current
or former CEOs on the corporate board.Because there is much greater potential for relevant information to be
shared in the decisionmaking process, it makes sense that small groups will
make better decisions than individual decisionmakers.[50]Even so, behavioral scientists have been saying for years that small
deliberative groups are prone to error in their decisionmaking if these groups
are made up of a majority of members who are similar in position on an issue prior to deliberations.[51]When they are, such groups can fall victim to what is referred to as “group
polarization,” the tendency of a small deliberative group with an initial
tendency to move in a given direction to move to even more extreme positions in
that direction following group deliberations.[52]This problem is especially relevant for groups who are like-minded and
possess a shared identity.[53]The corporate board is no exception to this problem.

It is easy to see how
corporate boards could become victims of group polarization.Insider board members and executive management
in general will have a greater degree of knowledge and understanding regarding
the true state of the company than the independent directors.Given this understanding, it is only rational
for outside independent board members to enter board deliberations with the
initial tendency to presume that the business judgments of insiders and
executive management are correct, creating a group of like-minded people.[54]Moreover, this initial tendency may be supported
by a significant number of outside board members who have a shared identity,
such as members who are current or former CEOs.These board members form a dominant “in-group”[55]
whose positions may polarize in order to conform to what they believe is the
typical position of the other in-group members.[56]Such a scenario promotes the dominant initial
position in discussion, limiting the argument pool and proceeds to an extreme,
as in-group members hear their peer group voice similar positions and become
more confident in their beliefs.[57]

C. Dysfunctional
Deference and Outside CEOs

In a previous essay,
we described in detail how we thought a phenomenon called “dysfunctional
deference” applied to certain critical decisions made by the board of Enron
prior to the company’s fall.[58]These decisions, made in 1999 and 2000,
allowed Enron’s Chief Financial Officer (CFO), Andrew Fastow, to establish and
operate the now infamous LJM private equity funds.The funds were set-up to acquire Enron assets
with the purpose of reducing the size of the company’s balance sheet.[59]Such an arrangement gave Fastow immense opportunities to engage in
self-dealing transactions at the expense of Enron and its shareholders.[60]Unfortunately, that is exactly what happened.[61]Ken Lay, Enron’s CEO at the time the funds
were created, knew of the controversial nature of this arrangement, and
therefore sought board ratification despite the fact that he had full authority
to approve the waiver on his own.[62]That in itself should have led to long and
intense board deliberations, yet very little in the way of deliberations were
reported prior to board approval, evidencing an incredible and surprising
deference to the recommendations of management.[63]

Deference by independent
board members to the opinion of insiders and executive management is
understandable and most likely beneficial to corporate board
decision-making.This asymmetric
distribution of information should be beneficial to board decision-making
assuming board insiders honestly share information about the pros and cons of a
prospective decision with the other board members during deliberations. However,
this deference to board insiders and executive management can also lead to
serious errors in decision-making if the deference is so pronounced that it
stifles deliberation of a corporate board’s most controversial decisions.Without deliberation, there is no opportunity
for board members to share potentially valuable information they may
individually have regarding the decision, making the board as a whole less
informed.When such extreme deference to
insiders and executive management leads to a stifling of board deliberations,
we refer to this as dysfunctional deference,[64]
a small group phenomenon that is distinguished from group polarization by the
lack of deliberation.

D. Limiting
Outside CEOs

In our essay on
dysfunctional deference, we recommended that a limit be put on the number of
outside directors who have been or are CEOs of large institutions—public or private—to
less than a majority of outside directors in order to reduce the potential for
over identification with insiders and executive management.[65]Such a background is conducive to identifyingwith executive management and perhaps viewing his or her
role on the board as making sure not to get in the way of what executive
management wanted to do.In the context
of executive remuneration, Professors Jensen, Murphy, and Wruck have already
applied this reasoning in recommending that the number of active CEOs on a
public company’s board be limited.[66]Indeed, initial statistical evidence has
borne this out.While Kaufman, Englander,
and Tucci have only found weak statistical evidence that the more CEOs on the
board of directors the higher the CEO compensation, they did find a strong
statistical association between the number of CEOs on a public company’s board
compensation committee and the level of CEO pay.[67]

Kaufman and Englander
recommend that no outside CEO serve
on three critical board committees: audit, nominating, and compensation.[68]
However, even though we are sympathetic to that recommendation, more research
needs to be done before we can give it our full support.Therefore, given the support provided by the
team production approach to board composition, it is our current position that
corporate boards of public corporations as well as their audit, compensation,
and nominating committees would be better off if they were composed of no more
than a minority of current or former outside CEOs.

III. Conclusion

As argued by
Professors Blair and Stout, corporate law directs a public company’s board of
directors to act as a mediating hierarchy.Taking a team production approach to board composition can enhance the
ability of a public company’s board to act as a mediating hierarchy.Based on the work of Kaufman and Englander,
the process for implementing such an approach is clear.First, the board nominating committee would
create a prototype board identifying the types of individuals that would best
represent the way the firm produces its goods and services as a team.Second, whether or not the individuals
actually selected for nomination by the board nominating committee would be
from inside or outside the company would be driven primarily by the board’s
independence requirements and whether qualified proxies can be found outside
the ranks of the company.If such
proxies are not available, the nominating committee would look internally to
the extent it can do so without violating its independence constraints.Third, outside CEOs would be selected to
serve on the board only so long as they add value in a team production approach
and without creating an imbalance of interests.Fourth, the board itself as well as its critical board committees, audit,
nominating and compensation, cannot have more than a minority of outside CEOs
as members.Thus, by implementing a team
production approach to board composition, a public company’s board should be
less prone to error.

1. A
publicly held firm is an economic organization “in which (i) management and
residual claimant status (shareholding) are separable and separated functions;
(ii) the residual claims (shares) are held by a number of persons; and (iii)
the residual claims are freely transferable and neither entry to nor exit from
the firm is restricted.”Michael P. Dooley, Two
Models of Corporate Governance, 47 Bus.
Law 461, 463 n.9 (1992).

2. Independent
directors are defined here as directors whose ties to the corporation are not
so significant as to influence their judgment in corporate matters.

21. ”If
‘control’ is the economically important feature of ‘ownership,’ then to build a
theory of corporations on the premise that ownership (and, hence, control) lies
with shareholders grossly mischaracterizes the legal realities of most public
corporations.” Id.
at 260–61.

25. See Blair & Stout, supra note 7, at 291 (“American law in fact grants directors
tremendous discretion to sacrifice shareholders’ interests in favor of
management, employees, and creditors, in deciding what is best for ‘the firm.’”).

27. See Bernard S. Sharfman, Being Informed Does Matter: Fine Tuning
Gross Negligence Twenty Plus Years After Van Gorkom, 62 Bus. Law. 135, 147 (2006), available at
http://works.bepress.com/bernard_sharfman/4/ (link).Moreover, because of indemnification and
D&O insurance, it is even rarer to find a case where the outside directors
actually had to use their own money to pay off a claim.Bernard S. Black, Brian R. Cheffins &
Michael D. Klausner, Outside Director Liability,
58 Stan. L. Rev. 1055 (2006) (link).

28. See Blair & Stout, supra note 7, at 279.A key
element in making this arrangement work is trust.The duty of loyalty is a means for creating
trust in the board to do the right thing for all team members, including
shareholders.Such a duty deters
directors from using their corporate authority to line their own pockets to the
detriment of all the other team members. Id.
at 316.

29. The
team production approach to corporate law is a particular type of stakeholder
model.Hansmann & Kraakman, supra note 17, at 447.Hansmann and Kraakman refer to this particular form of stakeholder model
as a “‘fiduciary’ model of the corporation, in which the board of directors
functions as a neutral coordinator of the contributions and returns of all stakeholders
in the firm.” Id.This is in contrast to another type
of stakeholder model which they describe as a “‘representative’ model of the
corporation,” where “two or more stakeholder constituencies appoint
representatives to the board of directors, which then elaborates policies that
maximize the joint welfare of all stakeholders, subject to the bargaining
leverage that each group brings to the boardroom table.” Id. at 448.

30. For
the seminal work on team production as a theory of economic organization, see Armen A. Alchian & Harold
Demsetz, Production, Information Costs,
and Economic Organization, 62 Am.
Econ. Rev. 777 (1972).According
to Alchian and Demsetz, “[W]ith team production it is difficult, solely by
observing total output, to either define or determine each individual’s contribution to this output of the cooperating
inputs.The output is yielded by a team,
by definition, and it is not a sum of
separable outputs of each of its members.” Id.
at 779.

31. Blair
& Stout, supra note 7, at 271–76.The mediating hierarchy model of the firm does not work where the firm
is subject to the control of one shareholder or a group of shareholders.Under those conditions, the lack of
independence impedes the ability of directors to act as mediating hierarchs. Id. at 309.

39. Id. at 290.Of course, there are exceptions to this
general rule.For example, the Van Gorkom court also found that the
directors’ breached their fiduciary duty of candor to shareholders by not disclosing
all material information necessary to make an informed decision on the merger
transaction.Smith v. Van Gorkom, 488
A.2d 858, 893 (Del. 1985).

43. Another
reason for protecting the centralized authority of the corporate board derives
from the advantages the board has in efficiently filtering information in its
decision-making process versus shareholders, other interested parties, and the
courts.See Sharfman, supra note 27 (arguing that corporate law needs to protect the decision-making
authority of the board based on both the board’s ability to act as a mediating
authority and efficiently filter corporate information).

52. Sunstein,
Deliberative Trouble, supra note 51, at 74.Professor Sunstein notes that the term “group polarization” is
misleading, as it can be mistakenly interpreted to mean that group members move
toward opposite positions. Id.
at 85.

54. Group
polarization is sometimes a product of cascade effects.Based on the prior description of
informational cascades, it is also easy to see how an informational cascade can
be the mechanism by which group polarization is facilitated in board
deliberations.See Sunstein, Deliberative
Trouble, supra note 51, at 81.

59. S. Rep. No. 107-70, at 7–8 (2002).The purpose of establishing these entities
was to help maintain the Company’s investment grade credit rating based on the
criteria established by rating agencies such as Moody’s and Standard & Poor’s.
Id. at 7.

63. While
there was no evidence of significant deliberations on the topic of the LJM private equity
funds at the three board meetings where they were approved, supposedly there was
a vigorous discussion of LJM2 at a board finance committee meeting prior to the
approval of LJM2.However, it is not
known whether Fastow’s conflict of interest, the economics of the transaction
itself, or both, was the subject of discussion.See id. at 28.

66. See Michael C. Jensen, Kevin J. Murphy
& Eric G. Wruck, Remuneration: Where
We’ve Been, How We Got to Here, What are the Problems, and How to Fix Them
55 (Harvard NOM Working Paper No. 04-28; ECGI-Finance Working Paper No. 44/2004
July 12, 2004), available at
http://ssrn.com/abstract=561305 (link).